Crisis Engulfs the Global Financial System

Headlines such as “Apocalypse now?”, “The Great American Slowdown”, and “Panic is in the Air” have dominated commercial financial media recently. The US Federal Reserve Bank has thrown its own rule book out the window to not just rescue Bear Sterns but the entire financial system. The British government has been forced to nationalise one of the big mortgage lenders Northern Rock. All the world stock market indexes have been in free fall for the last few months. No wonder billionaire George Soros called the current financial crisis the worst since the Great Depression.

The current crisis is not limited to FIRE (finance, insurance, and real estate) sector, although this is where it started. It is spreading like wild fire to other sectors of the economy. According to most estimates the US is already in a recession and the real question is how severe and for how long. Ben Bernanke, chief of the US Federal Reserve, and Henry Paulson, Secretary of the Treasury, along with the others are busy dousing the flames. Bernanke is a well known academic with expertise in the Great Depression and Paulson is the former Chairman and CEO of Goldman Sachs, one of the world's largest and most prestigious investment banks. As of now the fire in FIRE is still raging and could get worse. Bear Sterns is a case in point.

Bear Stearns’ Fire Sale

Collapse of Bear Sterns was the culmination of a week that shook American capitalism. Bear Stearns, the 85-year-old investment bank that had traded during the Great Depression, was sold at a fire sale price. The scale and speed of the collapse was mind boggling. This is a brief account of the last few days of Bear Stearns [1]:

Tuesday, March 11

The US Federal Reserve, invoking a clause not used since the Great Depression announces that it will lend up to $200 billion in Treasury bonds to investment banks for 28 days starting March 27. This is an attempt to douse the fires on Wall Street. Investment banks are elated. Bear Stearns feels comfortable with its capital base of approximately $17 billion.

Thursday, March 13

Bear Stearns's cash position has dwindled to mere $2 billion. Bear, to save it from creditors, plans to file for bankruptcy on Friday morning. If Bear could not repay several billion dollars to creditors on Friday morning, they would in turn start selling the collateral. The fire could engulf the forest.

Friday, March 14

As the news spreads the capital markets are at risk. There is a possibility of generalized flight from the markets. There is panic in the air.

Saturday, March 15

Henry Paulson, Secretary of the Treasury, is inundated with calls from Bank CEOs. They are nervous that a run on Bear Stearns could spread to all financial markets. The Federal Reserve and Treasury Department have to seal the deal between Bear Stearns and J. P. Morgan Chase latest by Sunday night i.e. before the Asian markets open.

Sunday, March 16

Federal Reserve governors get together again to approve borrowing directly to a non-bank. It borrows $30 billion to J. P. Morgan Chase for Bear Stearns. Treasury Department and Federal Reserve work non-stop to complete the deal before the evening. Bear Stearns is sold for $2 a share for a total of $236 million, which is a fifth of the value of its swanky headquarters office block.

J. P. Morgan acquired Bear Stearns for a fire sale price of $2 a share (raised to $10 later), which had a record share price of $172 in 2007. Not only has J. P. Morgan Chase acquired Bear cheaply, it has also saved itself from serious risk courtesy the US taxpayer. [2].

Leading up to the crisis several hedge funds, owned by Bear Stearns, Carlyle Group and other major banks had collapsed. Bear’s unmanaged collapse would have crashed the $4.5 trillion repo market, a decades old market where banks and securities firms extend and receive short-term loans, typically made overnight and backed by securities. This would have had unprecedented consequences for capital markets. No wonder the Democratic Senate Banking Committee Chairman Christopher Dodd, who worked with Bernanke and Paulson on Bear Stearns, said, "To allow this to go into bankruptcy, I think, would have [created] some systemic problems that would have been massive." [1]

The Financial Crisis

This is a major financial crisis far bigger than Bear Stearns. As The Economist has written, “Since the era of frock coats and buckled shoes, finance has been knocked back by booms and busts every ten years or so. But the past decade has been plagued by them. It has been pocked by the Asian crisis, the debacle at Long-Term Capital Management, a super-brainy hedge fund, the dotcom crash and now what you might call the first crisis of securitisation”[3].

As Charles Kindleberger, an economic historian of financial crises, explains the anatomy of a typical crisis as consisting of: displacement (new offering), credit expansion, speculative mania, distress, and crash/panic [4]. This crisis has its roots in the securitisation of mortgages (loans for people buying homes), specifically the collateralised debt obligation (CDO), a new offering. Over the years, CDOs and collateralised mortgage obligations (CMOs) increased in complexity with the mixture of high risk (sub-prime) and low risk mortgages. Large financial firms created structured investment vehicles (SIVs) for CDOs as off balance sheet conduits. They were in turn linked with these financial firms using the credit default swaps. The resulting expansion of credit increased the asset price mania, in this case sky rocketing house prices. Predatory lending practices targeted vulnerable people using sub-prime loans.

Later when interest rates increased and vulnerable people defaulted, distressed loans increased and house prices fell. As the asset price bubble burst, hedge funds and SIVs started to fail [5]. In March, Bear Stearns fire sale occurred. The lender of last resort, US Federal Reserve, has been in overdrive since summer of 2007. Other central banks, such as Bank of England, the Bank of Japan and the European Central Bank have also been supplying cheap money (by way of lower interest rates) and saving financial firms.

The “shadow financial system”, which is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions are at the heart of this crisis [6]. Nevertheless, the entire financial services industry has used debt, securitisation and proprietary trading to boost fee income and profits. Since 1980 financial-sector debt has increased from 10% of the size of non-financial debt to 50%. The value of outstanding credit-default swaps, for instance, has climbed to a staggering $45 trillion. Bear was counterparty to some $10 trillion worth of over-the-counter swaps [3, 7, 10].

The US financial-services industry's share of total corporate profits went from 10% in the early 1980s to 40% in 2007. This is striking as financial services comprise 15% of corporate America's gross value added and a mere 5% of private-sector jobs [3, 7]. These profits come at a huge cost. Investment banks are highly indebted and, hence, their debt-to-equity ratio is extremely high. For example, Goldman Sachs employs $40 billion of equity as the foundation for $1.1 trillion of assets; Merrill Lynch uses around $30 billion of equity as a foundation for $1 trillion of assets [3]. In rising markets, huge profits can be made but during falling markets shareholders can be wiped out. This is the lesson of Bear Stearns.

The total debt default losses, from mortgages to credit cards, have been estimated to be a minimum of $1 trillion (7% of US GDP). The losses could be as high as $2.7 trillion [8]. Analysing the losses the International Monetary Fund’s (IMF) April 2008 Global Financial Stability Report (GFSR) states “events of the past six months have demonstrated the fragility of the global financial system” and acknowledges that the “events are still unfolding” [9].

The Capitalist Crisis

Marxist-Leninists have stressed that financial crises are endemic to capitalism. The last few decades have been plagued by these crises. Three important trends from the recent history of capitalism, i.e. since 1974-75, are: financialization of capital accumulation process, international proliferation of monopolistic/ oligopolistic multinational corporations (MNCs), and slowing overall rate of growth. This monopolization has contradictory consequences: on the one hand it generates a swelling flow of profits, on the other it reduces the demand for additional investment in increasingly controlled markets: more and more profits, fewer and fewer profitable investment opportunities [11]. These MNCs increasingly and heavily rely on finance and speculation for huge profits.

A recent articles states, “The fact that such financialization of capital appears to be taking the form of bigger and bigger bubbles that burst more frequently and with more devastating effect, threatening each time a deepening of stagnation—i.e., the condition, endemic to mature capitalism, of slow growth, and rising excess capacity and unemployment/underemployment” [5] These crises are the crises of capitalism.

The US dollar is at its weakest since the era of floating exchange rates began in 1973 [10] and its hegemony is being challenged. World wide commodity/food prices are soaring and inflation is increasing while the mature capitalist economies are teetering into recession. US consumer sentiment is at a 26 year low. Since the consumer spending comprises 70% of US GDP, it could mean a prolonged recession. Imperial occupation of Iraq and Afghanistan is also failing and costs of war mounting. The conservative cost estimate is now $3 trillion [13]. This is a global capitalist and imperialist crisis.

The People Cost

The system is currently shifting the burden of this crisis onto the people. A significant section of them are already suffering. It is the weakest and most oppressed – including people of colour and women – who have to bear the brunt of the cost. For people of colour in the U.S., the monetary cost of the subprime mortgage crisis is estimated at $213 billion [15]. On the one hand workers’ incomes have stagnated, and the cost of healthcare, education, food, and gasoline keeps rising and pushing more people towards poverty. On the other hand, the wealthiest 1% of U.S. families is now garnering the largest share of income since 1929 [12].

There has been a net job loss of 232,000 since the start of 2008. Joblessness rose to 7.8 million in March and this does not include the 5 million who are forced to work part time. Predatory lending practices, from which financial firms profited, has now led to massive foreclosures. Nearly 1.3 million homes in the U.S were in some phase of foreclosure at the start of 2008 [14]. This is more than one in every 100 U.S. households. The City of Detroit’s foreclosure rate is 10 percent and in Michigan state over one million are now dependent on food handouts. The number of hungry and homeless people in U.S. cities has risen dramatically in 2007. Except for lip service the government has hardly provided any assistance.

The people are organising in these hard times. They are organising civil disobedience during housing re-possessions, picketing the banks and calling for a moratorium on foreclosures. A recent protest at the Policy Conference of Mortgage Bankers Association in Washington, D.C. people chanted “Mortgage bankers lie and cheat, people get thrown out on the street!” It is time for these movements to converge with the anti-war, anti-racist, immigrant rights, women’s and working class movements.

The global capitalist system is likely to suffer more crises and crashes. But crashes do not necessarily lead to new systems. A thousand wild fires are engulfing the global financial system. This is not enough to change the system. It is the heat from ten of thousands of internationally proliferating movements that has the potential to create a radically new social and political system.

End Notes

1. Sidel, R., Ip, G., Phillips, M. M., and Kelly, K., The Week That Shook Wall Street: Inside the Demise of Bear Stearns, Wall Street Journal, March 18, 2008.

2. Economist, Bear’s Pits, The Economist, March 17th 2008.

3. Economist, The Financial System: What Went Wrong, The Economist, March 19th 2008.

4. Kindleberger, C. P., Manias, Panics, and Crashes: A History of Financial Crises, John Wiley, 2000.

5. Foster, J. B., The Financialization of Capital and the Crisis, Monthly Review, April 2008.

6. Roubini, N., A Generalized Run on the Shadow Financial System, RGE Monitor, March 17, 2008.

7. Economist, Wall Street's Crisis, The Economist, March 19th 2008.

8. Roubini, N., Martin Wolf on My Estimates of Financial Losses: $1 Trillion is the New Size 6! RGE Monitor, March 11, 2008.

9. International Monetary Fund (IMF), Global Financial Stability Report (GFSR), April 2008.

10. The Economist, Central banks: A dangerous divergence, The Economist, March 19th 2008.

11. Sweezy, P. M., More (or Less) on Globalization, Monthly Review, 49:4, September 1997.

12. Lahart, J. and Evans, K., Trapped in the Middle: The incomes of most Americans have stalled, Wall Street Journal, April 19, 2008.

13. Stiglitz, J. and Bilmes, L., The Three Trillion Dollar War: on the True Cost of the US Invasion and Occupation of Iraq, 2008.

14. Data according to Moody’s Economy.com.

15. UFE, Foreclosed: State of the Dream 2008, United for a Fair Economy, 2008.

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